Outside the Box: I’m so confused: How do I treat withdrawals from a Roth IRA?

Q: I am unclear on how to treat withdrawals from a Roth IRA after I have made multiple partial conversions. I know each conversion starts its own “five-year-rule,” but I don’t see a clear way to know how to associate earnings with each conversion. I haven’t been able to find any information on how to treat earnings when multiple Roth conversions are made in the same Roth IRA. Can you shed any light on this for me?

— Chris

A.: Chris, it is not super simple, but is simpler than you fear. You do not have to associate earnings with any of the transactions in your Roth IRA. The accounting for this is done on Form 8606. The instructions for Form 8606 walk you through the process.

When you pull any funds from a Roth IRA, a set of ordering rules applies.

1. The first dollars out are deemed to be from your regular contributions. Since contributions are made after-tax, these withdrawals are tax-free.

2. Once you have distributed the equivalent of the total amount of your contributions, the next dollars out are deemed to be amounts converted more than five years ago. You would have paid the tax at time of conversion. Since these converted amounts are more than five years old, the five-year rule applicable to conversions is satisfied and no tax or penalty is due.

3. Next out are amounts converted less than five years ago. You would have paid the tax at time of conversion but not paid the 10% penalty that normally applies to amounts coming out of an IRA before age 59½. So, if you take out more than the contributions in #1 and the older conversions in No. 2 and are still under 59½, you pay the 10% when you get to these converted funds.

4. The last thing out after taking all prior contributions and conversions is by default the earnings. A second five-year rule is a factor here. For the earnings to be tax-free, it must have been at least five years since you opened your first Roth IRA, even if that account is not still open, and you must be at least 59½ years old. Therefore, if you take more than the amount in rules 1 to 3 above while under 59½, since the earnings have never been taxed while in the Roth, they are taxable, and you will also owe a 10 % penalty, unless an exemption applies. If you are over 59½ but it has been less than five years since you opened your first Roth, the earnings are taxable, but no penalty applies.

So, say you made $10,000 in contributions over the years, converted $20,000 six years ago, another $30,000 two years ago and the account is worth $70,000. The first $10,000 you take is tax-free (No. 1 above) as is the next $20,000 (No. 2). The next $30,000 (No. 3) removed is tax-free, if you are over 59½. If you are under 59½, you’ll owe a $3,000 penalty (10% of $30,000). The last $10,000 is earnings and is taxed based on item No. 4 above.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.

Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.

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